Australian (ASX) Stock Market Forum

'Hedge Fund' Blowout Threatens World Markets

6 May 2005
Decades of insane economic policies, and the stubbornness of central
banks papering over the symptoms of a systemic crisis by providing
ever more liquidity, have produced an impossible situation as of late
May, after the GM/Ford credit shocks.

One of the effects of this unprecedented liquidity pumping has been
the biggest explosion in mortgage and other private debt titles in
history, as well as the emergence of new financial bubbles in the
bond, housing, and commodity markets. All of these financial assets
are again just the basis for financial bets of even larger
proportions: "derivatives." As most of the derivatives bets are
traded outside of official exchanges, in the form of private deals
between two counterparties, nobody really knows the actual
dimensions. A substantial amount of derivatives betting is done
by "hedge funds," which are not subject to any kind of regulation or
supervision. According to the Bank for International Settlements
(BIS), the outstanding volume of OTC ("over-the-counter") derivatives
alone amounts to $248 trillion, while the annual turnover of exchange-
traded derivatives is close to $900 trillion. It's a conservative
guess to estimate the current rate of derivatives trading at $2
quadrillion per year; that is, 50 times more than the annual economic
activity, measured by the gross domestic product (GDP), of all
countries on the planet. (See Glossary of terms on derivatives and
hedge funds.)

On May 5, a big shoe dropped into this giant financial minefield.
Standard & Poor's downgraded $453 billion in outstanding debt of
General Motors and Ford Motor Corporation to junk. On May 8, Lyndon
LaRouche indicated that the General Motors crisis is not only
a "national disaster" for the United States, but could actually
detonate the world financial-monetary system. Two days after
LaRouche's statement, markets were shaken by the fear of an imminent
repeat of the Long-Term Capital Management (LTCM) disaster, which
almost destroyed the entire system in Autumn 1998. Stock and
corporate bond markets suffered massive losses on May 10, after
traders pointed to evidence of severe problems at several large hedge
funds, as a direct consequence of GM's and Ford's downgrading. The
hedge funds mentioned in this respect included Highbridge Capital,
GLG Partners, Asam Capital Management, and Sovereign Capital. The
London-based GLG Partners has $13 billion under management, and lists
as the largest hedge fund in Europe and the second-largest in the

GLG issued a statement on May 10: "All the funds are fine and we have
no concern." Highbridge Capital, that same day, wrote a letter to
investors, noting: "It is our understanding that recent volatility in
the structured credit markets is apparently related to the unwinding
of an unprofitable CDO [collateralized debt obligation] tranche
correlation trade by one or more parties.... The purpose of this
letter is to inform our investors that Highbridge has no exposure to
the trades." Highbridge was bought up last year by U.S. megabank JP
Morgan Chase. Sovereign Capital, a British hedge fund, is closely
linked to Lazard Brothers. The fund is heavily involved in East Asian
markets, and news of the possibility of its collapse had caused panic
among Asian bankers. Sovereign Capital's chairman, John Nash,
formerly worked for Lazard. Since May 10, the "LTCM-word" is in
everybody's mouth. Asam Capital Management is based in Singapore and
reportedly has lost most of its investors' money.

Top Banks Involved
The stocks of the same large banks that participated in the 1998 LTCM
bailout, and which are known for their giant derivatives portfolios””
including Citigroup, JP Morgan Chase, Goldman Sachs, and Deutsche
Bank””were hit by panic selling on May 10. Behind this panic was the
knowledge that not only have these banks engaged in dangerous
derivatives speculation on their own accounts, but, ever desperate
for cash to cover their own deteriorating positions, they also turned
to the even more speculative hedge funds, placing money with existing
funds, or even setting up their own, to engage in activities they
didn't care to put on their own books. The combination of financial
desperation, the Fed's liquidity binge, and the usury-limiting
effects of low interest rates, triggered an explosion in the number
of hedge funds in recent years, as everyone chased higher, and
riskier, returns.

There can be no doubt that some of these banks, not only their hedge
fund offspring, are in trouble right now. And the top banks are
starting to point fingers at each other. Particular attention has
been paid to Deutsche Bank. On May 17, Merrill Lynch issued a report
noting that Deutsche Bank probably has suffered significant
derivatives losses following the GM and Ford downgrading. The report
states that Deutsche Bank will not be able to maintain its rosy
performance, culminating in a pre-tax return on equity of 30% in the
last quarter. Not only has the volume of bond emissions managed by
Deutsche Bank dramatically declined during the second quarter, but
the bank may have suffered reduced business from hedge funds because
of the "recent turbulence" in the credit derivatives market, as well
as losses in its own trading positions. "Deutsche must be taking some
pain at present," concludes the report, which appeared just one day
before Deutsche Bank's annual shareholder meeting in Frankfurt.
According to Merrill Lynch, about 17% of Deutsche Bank's clients in
its debt sales and trading business are hedge funds.

When it was named as one of the victims of the GM/Ford fall-out,
Deutsche Bank chief financial officer Clemens Börsig was forced to
claim at a New York conference on May 11, that the bank "has no cash
lending exposure to hedge funds." Deutsche Bank's "exposure is fully
collateralized." Börsig said that the bank's global markets unit "has
no investments in hedge funds." The bank has a "conservative"
approach to its business with the funds and "very strict criteria"
for choosing clients, he added. Nevertheless, according to its own
2004 annual report, Deutsche Bank at the end of that year held
derivatives positions, mostly interest rate derivatives, of a nominal
volume of $21.5 trillion. That is about ten times the GDP of the
German economy.

'Hedging' to Death
The unprecedented downgrading to junk of almost half a trillion
dollars in corporate debt, which doubled the total volume of U.S.
junk bond debt, had devastating consequences for different kinds of
derivatives bets. In particular, the downgrading hit the credit
derivatives market, which provides insurance against bond defaults.
In the recent period, hedge funds have sharply increased their
exposure to a form of credit derivative known as a collateral debt
obligation (CDO). CDOs are pools of loans, bonds, and other debt
titles from hundreds of different corporations which are bundled and
sold to investors in much the same way as mortgages are turned into
mortgage-backed securities. In exchange for hefty fees, many hedge
funds have taken to selling insurance against corporate defaults. If
there is no default during the life of the contract, the seller
pockets a lucrative fee, but in the event of a default, the seller
must pay out the face value of the contract. To raise that money, the
hedge fund must often sell its most liquid assets, and that, often,
in the face of a falling market. Such "distress selling" by several
hedge funds was actually observed on May 10 and subsequent days.
Europe is extremely vulnerable to the current crisis in the credit
derivatives market, as 50% of all CDOs are euro-denominated. The same
kind of financial instruments led to the Parmalat collapse in Italy
last year.

A related kind of derivatives scheme is the so-called capital
structure arbitrage (CSA). It's one of the latest inventions in the
derivatives casino. CSAs also involve bets on corporate debt titles,
or the derivatives on that debt, such as CDOs. But the overall bet is
made more complex by adding another element: the stock price of the
respective corporation. Usually, when the prices of corporate bonds
or their derivatives falls, the stock price of the respective
corporation goes down as well. By combining the bond or credit
derivative with a bet on a falling stock price, the CSA investor can
try to "hedge" against potential losses. More convincing for hedge
funds than the limiting of risks, is the empirical discovery that
once a corporation runs into trouble, the stock price often plunges
much more violently than the bond price of the same corporation. And
that is exactly the condition under which a CDA contract generates

Now comes the problem: By the very combination””in the same week””of
Kirk Kerkorian's announcement for a partial General Motors takeover,
boosting the GM stock price by almost 20%, and the downgrading of GM
debt to junk by Standard & Poor's, crashing the GM bond price, the
arbitrage traders suffered the worst of all possible disasters.

Nobody knows how many hedge funds have already gone under in May.
Further complicating matters is the fact that many hedge fund
investors, faced with all the news and rumors circulating about
derivatives losses, are panicking, and are right now pulling out
their money””if they can. Hedge funds often allow withdrawals of funds
just once a quarter. The next date is July 1. But how to pay out
investors, when cash reserves are gone and every dollar of capital is
tied up in highly leveraged derivatives bets? To be able to meet
redemption demands, hedge funds are forced to liquidate contracts
under the present, extremely distressed, market conditions. This
means piling up even more losses, which in turn””once investors
recognize it””will further intensify withdrawals.

One indicator for the ongoing "distress selling" is the average price
of credit-default swaps (CDS), which on May 18 hit the highest level
since records started one year ago. For every outstanding corporate
bond, an investor can buy a CDS contract, by which the default risk
is transferred to the counterparty of the contract. In exchange for
this kind of protection, the investor pays a certain fee to his
counterparty, which works like an interest rate deduction on the
nominal return of the bond. Within ten days leading to May 18, the
average CDS rate has jumped up by one third, from 42 to 60 basis
points (from .42% to .6%). The sharp increase reflects not only the
rising fear for corporate bond defaults, but even more, a sudden drop
in the number of hedge funds that are willing, or able, to take over
additional default risks. The surprising rise of the U.S. dollar and
the fall of commodity prices, including oil, are also being
attributed to hedge fund emergency sales.

Beyond LTCM
Andrew Large, the deputy governor of the Bank of England, issued a
strong warning on credit derivatives on May 18. Speaking at an
international conference of financial regulators in Turkey, he
noted, "Credit risk transfer has introduced new holders of credit
risk, such as hedge funds and insurance companies, at a time when
market depth is untested." Large said the growth of derivative
instruments has "added to the risk of instability arising through
leverage, volatility, and opacity." Regulators should therefore act
and, in particular, search for credit concentrations.

Among the many voices warning against a repeat of the LTCM debacle or
worse, is non other than Gerard Gennotte, former senior strategist at
LTCM, and now working for another hedge fund called QuantMetrics
Capital Management. In statements picked up by London's Financial
Times on May 18, Gennotte pointed to the rising risk of a liquidity
crisis triggered by hedge fund blowouts, which then could lead to a
1998-style collapse. He emphasized: "You could expect something
similar to 1998, with people starting to liquidate their positions.
It starts with one position, but then they are afraid of getting
withdrawals, and it spreads across strategies."

In private discussions with EIR, an international financier confirmed
LaRouche's notion, that the downgrading of General Motors and Ford
debt was just the beginning of a much larger crisis hitting the
grossly over-extended global financial bubble””in particular the
derivatives scam. The financier said that the international financial
system is, in fact, facing a derivatives crisis "orders of magnitude
beyond LTCM." He observed that one can be certain that the Federal
Reserve, the President's Commission on Financial Markets (the so-
called "plunge protection team"), and the relevant departments of
major central banks around the world, are all on "emergency red-alert

Hedge funds and banks are, of course, all publicly denying reports of
a major derivatives blow-out. Any bank or hedge fund that admitted
such losses without first working a bail-out scheme, would instantly
collapse. Such implausible protestations of solvency are another
source of instability. The source further said that there is no doubt
that the Fed and other central banks are pouring liquidity into the
system, covertly. This would not become public until early April, at
which point the Fed and other central banks will have to report on
the money supply.

Regulating Hedge Funds
In response to the GM and hedge funds crises, Lyndon LaRouche issued
a statement May 14, "On the Subject of Strategic Bankruptcy," in
which he called for "new governmental mechanisms" for dealing with
these "strategic bankruptcies, bankruptcies with which existing
mechanisms of governments are essentially incompetent to deal."
LaRouche also renewed his call, from the early 1990s, for a
transaction tax on all derivatives trades, to regulate hedge funds.
By such a transaction tax, government authorities, for the first
time, could get an insight into the hedge fund activity. Currently,
there exist about 8,000 hedge funds worldwide, managing about $1
trillion in capital, compared to 4,500 hedge funds and $600 billion
in capital just two years ago. When LTCM was going under in 1998, for
every dollar of its capital, it had borrowed $30 from banks at was
running at least $400 in derivatives bets.

Allegedly, the average leverage of hedge funds today is much lower
than in the case of LTCM. At least one in ten existing hedge funds,
in most cases the smaller ones, are quietly being closed down every
year, while at the same time many more are being set up new.

A public debate on the regulation of hedge funds has already erupted
both in Britain and Germany. On top of the fears for a systemic
breakdown, there is the imminent concern that private equity funds
and hedge funds are, right now, taking over or manipulating the stock
prices of thousands of corporations in both countries. John
Sunderland, the President of the Confederation of British Industry
(CBI) came out with an attack on such funds, sounding similar to
German Social Democratic Party chairman Franz Münterfering's famous
earlier "swarm of locusts" statements. CBI Director General Digby
Jones raised the alarm bells concerning certain derivatives””
"contracts for differences" (CFD)””by which hedge funds are able to
secretly build up stakes in corporations.

In Germany, the chief executive officer of Commerzbank, Klaus-Peter
Müller, who also heads the German banking association, raised the
question: Why are we regulating small banks, while hedge funds,
moving much larger capital, are not being regulated at all?
Bundesbank board member Edgar Meister described hedge funds as
the "white spots on the map of supervisors," which are growing at
alarming speed. Even Rolf E. Breuer, who just resigned as supervisory
board chairman of the Frankfurt stock exchange (Deutsche Börse) after
losing a power fight with the British hedge fund TCI, has now
astonished the banking scene with a surprising conversion. The same
person who, as head of Deutsche Bank, had praised derivatives trading
as the shortest way to paradise on Earth, and become known in some
circles as Germany's "Mr. Derivatives," is suddenly denouncing the
short-term speculative investments of hedge funds, that are colliding
with the need for long-term productive investments and therefore
could "devastate the German economy."

Derivatives: 'Ticking Timebombs'
In an article headlined "Ticking Time Bomb in Structured Credit
Products," Switzerland's conservative financial daily Neue Züricher
Zeitung on May 19 pointed to the precarious situation in the so-
called "structured credit" market. This includes the use of capital
structure arbitrage (CSA) contracts, combined bets on the stock price
and debt titles of the same corporation. The daily states that the
purchase of GM stocks by Kerkorian caused a "brush fire" on the bond
market, which then, in particular, hit funds specialized in CDAs. The
funds faced "painful" losses when the risk premiums on GM
bonds "exploded" and the prices of related derivatives plunged, while
GM stocks, because of the Kerkorian move, jumped by 20%. Overall, the
downgrading of GM, in spite of "the fact that it didn't came as a
full surprise, triggered a chain reaction on the bond market,"
centered around collateralized debt obligations (CDO). These CDOs
fueled the "sudden explosion" of the GM risk premium. Trying to
escape from their CDO adventure, investors "at some point engaged in
panic selling, which then derailed the credit derivatives market." ””

Lothar Komp
Just thought we should revisit the 'hedge fund' topic in light of the rampant speculation in commodities.

Doesn't anyone else have GRAVE concerns about these stories we hear about hedge funds basing trading decissions on momentum?

Techical analysis is suited for the average Joe Blow (no offence site owner ;) ) to gain an insight into what the 'smart money' is betting on - based on their opinions of the fundamentals. The thought that these larger players whose money helps map the direction of the market are also playing the dumb trend following game is just asking for a disaster (ie sudden 50% overnight moves).
markrmau said:
Just thought we should revisit the 'hedge fund' topic in light of the rampant speculation in commodities.

Doesn't anyone else have GRAVE concerns about these stories we hear about hedge funds basing trading decissions on momentum?

Techical analysis is suited for the average Joe Blow (no offence site owner ;) ) to gain an insight into what the 'smart money' is betting on - based on their opinions of the fundamentals. The thought that these larger players whose money helps map the direction of the market are also playing the dumb trend following game is just asking for a disaster (ie sudden 50% overnight moves).

It's true, and it's reflected in COT data. The big fund traders get in deeper the longer a trend develops. Extremes in what the big funds and the commercials are doing( eg if the funds are REALLY long and the commercials are REALLY short) often signals the reverse in trend, as discussed elsewhere.
wayneL said:
It's true, and it's reflected in COT data. The big fund traders get in deeper the longer a trend develops. Extremes in what the big funds and the commercials are doing( eg if the funds are REALLY long and the commercials are REALLY short) often signals the reverse in trend, as discussed elsewhere.

Which reminds me, time to dig up COT data to post in the gold thread, only issue is they are a week old, that's far too long in the current climate. ... I might check your blog wayne to see if you have stuff on it....
Just read this:

David Threlkeld, a veteran copper trader, said the market had been "out of control" for months, allowing speculators to run roughshod over industrial producers and users. "The LME has been seduced by hedge funds, [which have] pushed prices to levels unsupported by fundamentals. There's a vacuum below and the crash could set off a chain of margin calls running through the whole commodities sector. We've got a crisis on our hands and it is a lot bigger than copper," he said.
wayneL said:
It's true, and it's reflected in COT data. The big fund traders get in deeper the longer a trend develops. Extremes in what the big funds and the commercials are doing( eg if the funds are REALLY long and the commercials are REALLY short) often signals the reverse in trend, as discussed elsewhere.


those hedge funds can go short at any time, its scary what may happen then
nizar said:

those hedge funds can go short at any time, its scary what may happen then

Where's Dr Mahathir Mohamed when you need him? We can all blame the mysterious hedge funds when things go awry. Those dastardly speculators.

Banks face vast losses in copper mayhem

By Ambrose Evans-Pritchard (Filed: 13/05/2006)

The spike in copper prices over recent weeks has left a group of banks and operators on the London Metal Exchange (LME) nursing vast losses, raising concerns about the stability of the commodities market.

Simon Heale unexpectedly said that he would be stepping down by the end of the year
The banks have been caught out by a sudden widening in the gap between the price of three-month futures and that of long-term futures, for December 2010 or April 2011.

Copper surged this week to an all-time high of $8,875 a tonne, rising almost 10pc on Thursday. Yet futures prices for April 2011 are just $3,778 a tonne.

Copper has doubled in price this year even though industrial demand is flat.

"This is fairyland," said Richard Elman, head of the Noble Group. "We have never seen such a disconnect between reality and pricing of raw materials. The long-term story is sound but the short-term froth is patently frightening."
This article may be of interest.

By Peter Brimelow, MarketWatch
Last Update: 12:01 AM ET May 11, 2006

NEW YORK (MarketWatch) -- All eyes are on the Fed, and one respected institutional service thinks there are reasons to dislike what they're seeing.
It's nearly eight years since the Long-Term Capital Management hedge fund cratered. At that time, the Federal Reserve engineered an extraordinary bailout on the (highly debatable) theory that the financial markets would otherwise be fatally disrupted.

What would happen if there was another LTCM today?

The Connecticut-based institutional service Bridgewater Daily Observations, which itself manages over $150 billion, has been asking this disturbing question and getting a fairly disturbing answer.

In recent issues, Bridgewater pointed out that money invested in hedge funds is now five times higher than in 1998, when the LTCM debacle occurred.
Bridgewater also tried to show through a sophisticated analysis that hedge funds do tend to march in lockstep. That means, paradoxically, that they are vulnerable to the same things: "tight credit, widening credit spreads, and falling equity markets."

Bridgewater's summary: "We estimate that an unfavorable environment, in degrees comparable to 1994, 1998, and 2000/01 will cost ...equally to about 2/3 of the S&L crisis and twice the size of the Mexican default in 1994 - i.e. it is material, but not system threatening."

That's the good news. The bad news: "'the system can withstand a moderate economic crisis (like those that occurred post-1993) but not a major one (like 1974)."

Bridgewater estimates that losses with the current hedge fund regime would have been $80-$100 billion in the post-1993 crises, $300-$350 billion in 1974 (and $500-$600 billion in 1929).

And then there's the REALLY bad news: Bridgewater also expects a major international system crunch exactly like the collapse of the fixed exchange rate Bretton Woods system, which lead directly to the inflationary crisis of 1974. See my March 16 column ({B08B1127-327B-4433-9867-84EC34016FC9}&siteId=mktw)

Wednesday morning, Bridgewater's Daily Letter was headlined, "The Tremors Before the Big One" and concluded: "We believe the odds of a dollar/ U.S. debt crisis in the next twelve months are elevated (say 50 percent)."

A week earlier, Bridgewater pointed squarely at China's manipulation of its exchange rate and at new Fed Chairman Ben Bernanke's handling of the situation.

In an issue titled "Bernanke's Test begins," Bridgewater wrote: "Today's imbalances are much larger and global in scale. They have been sustained for a longer time because China, and many other countries, are not defending a declining currency with shrinking reserves. Instead, they are resisting rising currencies with increasing reserves, a much more sustainable action."

The result, according to Bridgewater: "bigger imbalances that have taken longer to build, have been sewn deeper into the economic fabric, and will take much longer to unwind, with dramatically larger financial consequences."

Bridgewater's savage summary: "...Now you've got a new, academic, waffling Fed chairman, a falling dollar, a falling bond market, rising gold and commodities prices, and an underperforming stock market all with a giant current account deficit ..."

Its caustic conclusion: "Bernanke is rapidly losing control."
It is my opinion, based on observation of history, that once the Fed starts a series of interest rate rises they keep going until something in the economy breaks. The only questions being what breaks, when it breaks and what the consequences are.

My only prediction as to actual events at this stage is that we're about to see a serious US Dollar rally going higher and lasting longer than most expect followed by a serious fall to new lows. That's simply a contrarian view based on my observation that Dollar bears are getting a little too excited at the moment so it's time for an up move. I could, of course, be wrong with that observation.

To me, this implies that the Fed isn't finished raising interest rates yet (neither is the RBA) and will keep going until a genuine crisis develops. Most likely IMO that will take the form of a bond market slump very quickly leading to falls in real estate prices given the relationship between the two markets. There is increasing evidence that, in the US, this is already underway on a limited scale. After bonds fall there are then implications for commodities, gold, stocks etc.

In short, I'm bullish on yield especially bonds and property. :2twocents

(The above is my opinion only and I'm not a qualified financial advisor so do your own research before investing.)
Smurf1976 said:
My only prediction as to actual events at this stage is that we're about to see a serious US Dollar rally going higher and lasting longer than most expect followed by a serious fall to new lows. That's simply a contrarian view based on my observation that Dollar bears are getting a little too excited at the moment so it's time for an up move. I could, of course, be wrong with that observation.
Not totally disagreeing, but USD weakness has in my view a lot further to run before the upswing - there are definite cycles.
If you are right, then gold will hold steadier (not rise as sharply) during the return of dollar strength.
And if the cycles run to plan, then we are probably looking at return of dollar weakness by last quarter, which coincidentally is gold's typically strongest period of the year.
All this analysis suggests is that gold is a great hedge to the hedge funds hegemony.
Smurf1976 said:
That's simply a contrarian view based on my observation that Dollar bears are getting a little too excited at the moment so it's time for an up move.

Interesting POV. One trigger for this scenario would be a big drop in crude this week with the IEA forecasting a drop in oil demand in 2006, and a reduction in sabre rattling over the iran nuclear issue.

This would alleviate inflation concerns, and cause a big drop in gold. I suspect copper would be slaughtered too as copper is taking on the same 'anti inflation' status as gold.
An interesting article on the the risky activities that hedge funds get up to. American hedge fund Amaranth's downfall was the result of letting a young (gun) trader Brian Hunter (who made the firm hundreds of millions in 2005) bet on natural gas prices and gaps - which went horribly wrong.

Hunter's natural gas positions "became more than half of the entire firm's exposure, even though Amaranth claimed to be a "multistrategy" fund".

However, one thing is different from previous downfalls of hedge funds. When Long-Term Capital Management hedge fund collapsed in 1998, global financial markets were under threat. Nowadays, the failure of Amaranth (which comes just a month after fellow hedge fund MotherRock was closed) has barely caused any instability - which just goes to show how large and sophisticated the hedge fund industry has become.

Hedge Fund's Collapse Met With a Shrug
Amaranth's Loss in Natural Gas Gamble Not Seen as Affecting Broader Market

By Steven Mufson
Washington Post Staff Writer
Wednesday, September 20, 2006; Page D01

When the high-powered Long-Term Capital Management hedge fund imploded in 1998, two dozen of Wall Street's most powerful bankers and brokers assembled with the New York Federal Reserve governor to devise a $3.5 billion bailout plan to prevent a bout of panic selling in world markets.

But this week, when the Greenwich, Conn.-based hedge fund Amaranth Advisors LLC announced that it had suffered losses just as big as LTCM's, markets shrugged. There were no summit meetings at the New York Fed. J.P. Morgan & Co. and Merrill Lynch & Co. quietly took over and started selling off Amaranth's portfolio of ill-timed natural gas futures. The major damage is expected to be felt by people wealthy enough, and foolish enough, to have invested in Amaranth.

"There's no systemic risk. The market can absorb this," said Peter Fusaro, co-founder of the Energy Hedge Fund Center, which tracks 520 energy hedge funds. "It's a hiccup."

The reasons for the difference? LTCM borrowed heavily, and it lost badly on a roughly $1 trillion position in currency and Treasury markets. Its failure threatened the stability of banks, and a fire sale of its assets would have hit securities held by almost every fund and investor.

Amaranth also engaged in rash trading, hedge fund managers and commodities traders said. But it borrowed less heavily, and its positions were smaller and focused mostly in natural gas futures. As a result, the firm's downfall has made barely a ripple in broader markets.

"No one got hurt except sophisticated people," said the manager of another multibillion-dollar hedge fund, who spoke on condition of anonymity to preserve his business relationships. "They took fliers. They made money. They lost money."

They lost a lot of money, almost entirely in a natural gas market that gets tossed about by geopolitical anxieties, the vagaries of weather and the limits of an unwieldy storage system for the fuel.

To many investors, the failure of Amaranth feels more like a serious case of indigestion than a hiccup. Over the past five years, the amount of money invested in hedge funds engaged in energy trading has soared, from about $5 billion to more than $100 billion, according to some estimates. Those investors include not only wealthy individuals, but also endowments and pension funds seeking to diversify out of traditional stocks and bonds.

While most of those investors realize that trading in energy markets is risky, Amaranth's plunge is a reminder of just how risky it can be. Amaranth's co-founder and chief executive, Nicholas Maounis, said in a letter to investors that the fund was "aggressively reducing our natural gas exposure" to meet payments to creditors. He said that the fund, which was up sharply in August, would be down 35 percent for the year after the sell-off.

Amaranth's downfall also bears unsettling similarities to the failure of LTCM. Both firms engaged in spectacularly large wagers, taking up such big portions of their markets that it became difficult for them to unravel their positions. Like LTCM's Nobel Prize winners and other stars, Amaranth's partners possessed a confidence built on past success and untroubled by the possibility of failure. The company bragged on its Web site of "moving nimbly and effectively within an ever-changing investment landscape" and said that its employees "possess fearlessness with respect to complexity, learning, as well as invention, and continuously strive for perfection." Maounis, a convertible-bond trader, said he had chosen the company's name, which means "unfading" in Greek.

Yet experts in commodities trading and natural gas markets said yesterday that Amaranth, which had $9 billion in assets just three weeks ago, had been far from perfect. It had allowed one of its star traders, Calgary-based Brian Hunter, to take huge positions in natural gas. According to the Wall Street Journal, which interviewed Hunter earlier this year, the 32-year-old trader was up $2 billion for the year at the end of August.

To make that much, Hunter must have had "an unconscionably large position for this market," said a hedge fund manager with years of experience in commodity markets who spoke on condition of anonymity for business reasons. A firm such as Goldman Sachs Group, one of the biggest players in energy markets, would typically take positions less than a tenth as big as Hunter's, traders said. One veteran energy trader said Hunter's positions were often twice as big as the next biggest.

Amaranth and Hunter declined to comment for this article.

Natural gas traders said Hunter took risky positions, too. He bet that the price of winter natural gas would rise and that the price of summer gas would fall -- the opposite of what has happened. He also bet that the gap between the March 2007 natural gas price and the April 2007 would increase. Instead, it fell from about $2.60 per 1,000 cubic feet to about 80 cents.

Earlier this year, Harry Arora, a former Enron Corp. energy trader who had hired Hunter at Amaranth, had a falling out with Maounis and Hunter over the risks the firm was taking, say people familiar with the situation. Maounis, impressed that Hunter made hundreds of millions of dollars for the firm in 2005 after Hurricane Katrina sent natural gas prices soaring, made the young Canadian a co-head of commodities trading.

In addition, he let Hunter increase the size of his natural gas positions so that they became more than half of the entire firm's exposure, even though Amaranth claimed to be a "multistrategy" fund. Before Hunter's arrival, all commodities positions made up about 20 percent of Amaranth's portfolio, natural gas no more than 7 percent.

The size of the positions that Amaranth was letting Hunter take was no secret. It was disclosed to investors, such as major investment banks that included stakes in Amaranth as part of their "funds of hedge funds." Typically, the investment banks market their expertise in choosing the best hedge funds. Yet Morgan Stanley, for example, invested $126 million, or about 5 percent, of its $2.3 billion fund of hedge funds in Amaranth. Without naming Amaranth, Goldman Sachs Dynamic Opportunities Ltd., another fund of hedge funds, said yesterday that "significant" losses on an energy-related investment would shave as much as 3 percentage points off its return this month.

Amaranth's fall is almost certainly going to come under scrutiny from members of Congress who advocate federal oversight of the essentially unregulated hedge funds, especially as the $1 trillion sector opens its doors to more investors.

Just last week, New York Fed Governor Timothy F. Geithner expressed concern about the ability of hedge funds to take on a lot of leverage without disclosing it. And he warned that hedge fund failures could hurt market participants other than those investors and lenders who have chosen to do business directly with those funds. In a speech delivered in Hong Kong, Geithner said the growth in hedge funds "will force us to consider how to adapt the design and scope of the supervisory framework to achieve the protection against systemic risk that is so important to economic growth and stability."